At the recommendation of my friend Bobby, I have started to read “A Random Walk Down Wall Street”. This book is known as one of the premier investment books and a modern day classic. I am slowly working my way through it, and I am sure you will hear me reference this book a lot as I read it. However, today I wanted to share a simple tidbit from the first chapter.
The author, Burton Malkiel, references two different theories with regard to investing based on what the prospects of the future hold. He calls these two theories, “The Firm Foundation Theory” and the “Castle-in-the-air Theory”.
The Firm Foundation Theory assumes that there is an intrinsic value for all stocks. Something is either undervalued, overvalued, or at the right price. Discovering what is undervalued or overvalued, and playing the market in the right direction until the stock reaches equilibrium is the way this theory works. This also epitomizes the ‘buy and hold’ strategy of investing. For example, lets assume Microsoft’s stock has been in the tank for some reason the past handful of months. You know they will bounce back eventually; it’s only a matter of time. So you buy the stock when it’s low, and hold onto it. Eventually it will come back to its equilibrium value, and you made yourself a nice profit. Warren Buffett is the perfect example of someone who has made billions using strategies similar to this.
The Castle-in-the-air Theory was put forth by legendary economist John Maynard Keynes. In layman’s terms, Keynes felt that investors were better off and would rather catch trends on the upswing, and then sell their stake in the trend at its peak. For example, if you bought a crate of Tickle Me Elmo’s back in the summer of 96 for $30 a piece, you could have bought yourself a couple of cars if you sold your stock in early December of 96. However, if you bought that same crate of Elmo’s in late December, and held onto them until January, you stood to lose a lot of money. The Castle-in-the-air theory takes advantage of trends. If you get in on a hot stock before anyone else, and exit just as it’s starting to plateau or fall, you have done well. This theory focuses on consumer psychology more than on actual valuation of stocks.
There will be more to come from this book, but these were interesting enough theories to share. If you have read the book, or if you have other investing books to recommend, please leave a comment below.